A Smart Way to Play Small-Caps

This is the heyday of the has-been, the moment in the economic cycle when third-rate stocks in fourth-rate industries get a second chance at romance. Just as the list of shares making new one-year lows reads like the NYSE's who's who, the list of new highs looks like the roster for a bowling league in Bakersfield.

Rather than mope about this turn of events, American investors should throw their hats in the air and cheer. What has happened to our love of underdogs? Our appreciation for the disabled kid from a broken home who beats the preppies at the national spelling bee? Our admiration for the spunky young Diamondbacks knocking off the venerated Yankees?

When it comes to almost every other activity in this land, we root on the side of the disadvantaged. But when it comes to stocks, most investors tend to go old school. In that sense, the continuing bear market for blue-chip stocks could have a salutary effect: pushing more people to take on the risk of funding innovation at thousands of smaller firms that need and deserve their funds more.

Bummed that once-beloved, now-berated Bristol-Myers Squibb (BMY Quote) is hitting a five-year low? Maybe you'd feel warmer in Burlington Coat Factory (BCF Quote); its TV ads may be cheesy, but shares are at a one-year high and heading steadily toward an all-time peak posted in 1998.

Or consider iron miner Cleveland-Cliffs (CLF Quote) for the same reason. Or cardboard-tube maker Caraustar Industries (CSAR Quote). Or rolled steel manufacturer Steel Technologies (STTX Quote). Or trousers maker Haggar (HGGR Quote). All are small, cheap stocks in forgotten businesses rising slowly but steadily from multiyear lows toward all-time highs.

Try iShares for Targeted Investing

The only problem with jumping into these stocks wholesale is the haunted memory of the last time a wide swath of stocks of different stripes rose indiscriminately. You may recall that part of the reason we got into trouble in the bubble years of 1998 to 2000 was that investors learned that they didn't need to individually pick good big companies to support. They could just buy a basket of 500 of them, in the case of funds tracking the S&P 500 index with the SPDR Trust (SPY Quote), or 100 of them, in the case of funds tracking the Nasdaq 100 Trust (QQQ Quote).

As big-cap indexing became increasingly popular for everyone from the man on the street to major pension funds, torrents of money pushed up the values of the worst members of those indices as well as the best. Much of the damage that has been visited upon owners of those funds can be attributed to the slow unwinding of positions in undeserving companies like Kmart (KM Quote), JDS Uniphase (JDSU Quote) and WorldCom (WCOM Quote).

The new instruments of choice for momentum investors who wish to pile willy-nilly into a basket of small-caps are stock-fund hybrids called iShares. Invented by Barclays Global Investors a couple of years ago as a twist on what used to be called unit investment trusts, iShares are laser-guided missiles compared with the dumb-bomb technology of S&P 500 mutual funds.

They enable you to invest in the three major Standard & Poor's indices -- the big-cap S&P 500, the MidCap 400 and the SmallCap 600 -- in nine different ways. (The three major market indices from Russell -- the big-cap 1000, the small-cap 2000 and the combined 3000 -- can likewise be split nine ways.) In addition to straightforward purchases of iShares representing the indices themselves, you can buy just the half of each index that represents relatively expensive "growth" stocks or the half that represents relatively cheap "value" stocks.

The disparity in returns between the two extremes in the S&P indices is striking: The iShares representing the S&P SmallCap 600 Value (IJS Quote) is up 35% since the birth of the bear market in September 2000, while the iShares representing the S&P 500 Growth (IVW Quote) is down 38%.

This has not escaped the notice of large hedge funds, as you might guess, because they never miss a chance to jump on the momentum bandwagon by engaging in a practice called "stat arb," short for statistical arbitrage. One hedge fund manager told me that ever since his firm's analysts had determined "there was a bull market in value," he has made it a practice to take advantage of the synchronous difference between the two iShares by simply buying the S&P SmallCap 600 Value and simultaneously shorting the S&P 500 Growth.

It's easy to see that the former has become increasingly popular in the past year, as average daily trading volume has leapt from about 25,000 per day a year ago to about 150,000 per day. Likewise the iShares Russell 2000 Value (IWN Quote) has risen from about 60,000 shares a day a year ago to about 350,000 a day now.

This method of investing clearly has merit for small investors: iShares cost much less than mutual funds. Plus, it puts fresh change in the pockets of small companies such as Burlington Coat and Haggar that were left behind the bull market in growth of the late 1990s. But it's fair to start worrying early about the endgame. Index diversification ultimately corrupts the true value of many companies, as all constituents of an index -- the angels and the devils -- are lifted simultaneously.

Last week I spoke to San Francisco-based portfolio managers Patrick O'Connor and Alain Cubeles, the Barclays folks in charge of these funds. O'Connor said his Russell small-cap funds have rocketed 10 times in size in the past year -- from $200 million to $2.5 billion in net assets. Cubeles said that they have begun to study troubling questions of liquidity in funds that must accommodate massive daily inflows of money into stocks that often have less than 10 million shares outstanding. "But it is still doable," he said. "In fact, we think we can get much bigger."

Another Way to Play

It remains to be seen whether Cubeles' optimism is merited. In the meantime, I like iShares for their low cost, ease of purchase, flexibility, predictability and tax efficiency, The SmallCap 600 Value fund is currently a cornerstone of my retirement account, although that can change at any time.

And it's easy to layer additional iShares into a portfolio to create a diversified portfolio on the cheap -- e.g., 10% in the iShares representing big-cap growth, 10% in iShares Russell Midcap Growth (IWP Quote) ; 10% iShares Dow Jones U.S. Consumer Non-Cyclicals (IYK Quote); 10% in iShares South Korea (EWY Quote); 10% in iShares S&P Europe (IEV Quote). You buy each of these just like stocks at your brokerage -- or, if you're forecasting a decline, you can short them.

Yet, I can't help wondering if it's possible to take advantage of the phenomenon of small-cap indexing in an offbeat way. Here's an idea: Standard & Poor's publishes a list of the constituents of each of its index funds on its Web site. I downloaded the table of the SmallCap 600 Value members into an Excel spreadsheet -- there are 380 of them -- then added some data to the sheet via a macro available to everyone who owns the Office 2002 version of the program. I calculated how close each stock is to its 52-week high, then ranked them from high to low on that ratio (price/52-week high), figuring that would tell me which were the most popular. Then I segregated the ones trading at new highs, and reranked them by price from low to high.

My speculative bet is that, all things being equal, the ones with the lowest absolute price and best momentum might outperform the whole index over the next three months. If the S&P 600 SmallCap Value stat-arb trade continues in the current direction -- which is not a sure bet -- these low-priced value stocks could potentially offer the most bang for your buck regardless of their individual merit.

I've listed the top 25 here. I'm not adding any to the SuperModels portfolio, but I will monitor their progress and update you in a few months.

Low-Priced Small-Caps Stay tuned for an update on how these value stocks perform
Company	April 12 price	52-week high	52-week low
Ashworth (ASHW:Nasdaq)	$8.99	$8.99	$4.34
Haggar (HGGR:Nasdaq)	14.00	14.00	10.05
Lennox (LII:NYSE)	14.59	14.59	7.89
Myers Industries (MYE:NYSE)	15.34	15.34	10.70
Bowne & Co (BNE:NYSE)	15.35	15.35	8.94
Standard Motor Prod (SMP:NYSE)	16.40	16.40	9.80
Penford (PENX:Nasdaq)	17.06	17.06	8.78
ShopKo Stores (SKO:NYSE)	21.55	21.55	6.65
Volt Information Sciences (VOL:NYSE)	21.65	21.65	10.50
Anchor BanCorp Wisconsin (ABCW:Nasdaq)	21.85	21.85	13.20
South Financial Group (TSFG:Nasdaq)	22.00	22.00	14.01
First American (FAF:NYSE)	23.10	23.10	16.30
Standex International (SXI:NYSE)	25.85	25.85	18.32
Timken (TKR:NYSE)	26.00	26.00	11.75
Schweitzer-Mauduit (SWM:NYSE)	26.05	26.05	17.80
Cleveland-Cliffs (CLF:NYSE)	26.45	26.45	13.65
Gardner Denver (GDI:NYSE)	26.75	26.75	17.65
New England Bus. Svc. (NEB:NYSE)	28.60	28.60	15.86
Selective Insurance (SIGI:Nasdaq)	28.91	28.91	19.36
Kilroy Realty (KRC:NYSE)	29.64	29.64	22.80
Northwest Natural Gas (NWN:NYSE)	29.95	29.95	21.65
La-Z-Boy (LZB:NYSE)	30.12	30.12	14.70
Reliance Steel & Aluminum (RS:NYSE)	30.59	30.59	20.50
Chittenden (CHZ:NYSE)	30.90	30.90	21.75

Fine Print

An iShares spokeswoman said her company planned to introduce six new iShares over the next 12 months that will allow passive index investments for the first time in fixed income.